Financial Crisis Inquiry Commission · Web view2016/03/11 · And that is, to get your opinions on...

FCIC Interview of Gary Gensler, May 14, 2010

United States of America

Financial Crisis Inquiry Commission

INTERVIEW OF

GARY GENSLER

Friday, May 14, 2010

*** Confidential ***

1


Financial Crisis Inquiry Commission

Friday, May 14, 2010

--o0o--

MR. SEEFER: Thank you very much for taking

the time --

MR. GENSLER: You’re the diagnosis commission,

right?

MR. SEEFER: -- to talk to us.

The diagnosis commission?

What are the contributing causes to the

financial crisis, that is our charge by the statute that

was passed last year. And as I told Tim, who I suspect

told you, one of the areas we’re looking at now in depth

is the role of derivatives in the financial crisis, the

role of regulation or lack thereof of derivatives, and

whether or not that contributed to the financial crisis;

and, of course, who better to talk to about that than

the Chairman of the CFTC.

So that’s why we wanted to talk to you. And I

will tell you what I have been doing with folks like

you, is really just asking the broad-based question in

the beginning, and then following up. And that is, to

get your opinions on what role, if any, derivatives

played in either contributing to the financial crisis or

acting as a propagating mechanism; what the role of

2


regulation or lack thereof was; and since you are

chairman of the CFTC, what role regulation should be

playing now, since I know you guys are involved and have

a little legislation going on right now.

MR. GENSLER: Okay, and you want me to do that

in 30 minutes, or in seven minutes or less?

MR. SEEFER: Yes, so we can follow up.

MR. GENSLER: And I noticed the tape recorder.

So I’m on the record, and this is -- does this

transcript go -- is this -- I mean, I always have to

just always check because I’m a public figure. What

is -- is this a transcript for --

MR. SEEFER: This is a transcript primarily

for the record, for the commissioners who, a lot of

them, like to listen to this. It can be designated

“confidential,” if you would like it to be designated

confidential, and you can get copy of it, if you would

like to get copy of it.

MR. GENSLER: No, I just need to know. I

mean, if it’s a public thing for the record, I should

have had Scott here, too –- then I just know I’m on the

record. And I’ll just find my words more thoughtfully.

MR. SEEFER: Yes, it is an on-the-record

interview.

3


MR. GENSLER: On-the-record, public transcript

interview.

MR. SEEFER: Well, we’re not going to make it

public if you want to designate it ”confidential,”

unless the commissioners decide to make it public. And

if they decide to make it public after somebody deems it

confidential, we give notice to those folks, and hear if

they have any objections. And they take that seriously.

And it requires you, chair, and vice-chair to agree or

for the majority of the Commission to --

MR. GENSLER: What do most people do that

you’ve been interviewing? What’s your standard

operating procedure?

MR. SEEFER: The standard operating procedure

is, most folks have not said, “I want this designated

confidential.” Some have, and we’ve said, “Fine.”

MR. GENSLER: Public, just the nature of my

answers, I have to think a little bit more.

I think the financial system failed America.

I think the regulatory system failed. It’s not one or

the other, to me.

I think the work of your commission is really

important.

4


I think derivatives played a role. I think

that wasn’t the only factor. And I’ll quickly touch

upon some of the other factors.

No doubt, you’re studying, you’re well into

the weed of. But then I’ll talk about derivatives as

long and as in depth as you want. But I think that we

have, as a nation, very significant economic imbalances.

You know, we went into this period of time with low and

declining savings rates. And these are global

imbalances. Very high savings rates in Asia,

particularly in China and in the Middle East.

I think we left the nineties with an asset

bubble in the securities market that -- usually asset

bubbles, not always, are a sign of imbalances in your

whole economy; but that that -- not directly, but we

sort of moved into an asset bubble in the real-estate

market, both residential and commercial.

I think a contributing factor, though there’s

great debate on it, is the low interest rates at the

Federal Reserve, the very easy monetary policies of the

early decade.

I appreciate and respect there are others that

debate that and have a different view on it.

But these global imbalances -- you know, the

evidence of it, very low savings rates, significant

5


trade imbalances, of course, moving from budget

surpluses to budget deficits.

And you can see it also in the markets, the

credit spreads, the spread that is being charged in

markets for risk. It’s basically a risk premium, where

it was diminishing. The risk premium crossed a number

of years in the mid-decade that kept -- whether it’s

measured in swap spreads, corporate bond spreads, the

pricing of junk bonds at risk premium. Now, risk is

always within society -- risk is always within markets.

But we had an asset bubble that also moved into the

commodity markets, which is something the CFDC

oversees -- you know, the commodity markets.

A second factor well beyond those global

imbalances, I think, is -- I’ll just hit a few, I

think -- and I’m sure you’re studying every one of

these -- but the mortgage underwriting practices and the

whole pipeline, from the -- we took a look at this when

I was in the Clinton Administration in 2000, to Andrew

Cuomo’s credit and Larry Sommers was then Treasury

Secretary, I was asked to work with Andrew Cuomo.

Michael Barr and I were to work with him. And we went

around the country and we sort of studied what was then

called “predatory lending.” It seems like it picked up

a different name later, “subprime lending.”

6


And we put out a report -- the Treasury and

HUD put out a report in the spring of 2000 that had a

series of recommendations about subprime lending, which

was about predatory lending. Ned Gramlich at the

Federal Reserve, was very helpful.

I remember testifying with Ken Apgar of the

FHA on a series of recommendations. They lasted on

Capitol Hill a very short time. I mean, there wasn’t

much appetite or mood to take these recommendations.

And even the recommendations at the Federal Reserve

itself could do, the Federal Reserve didn’t do. It was

around -- what was that law, HOEPA and the protections

you could have.

I’m not suggesting that if everybody listened

to the joint Treasury-HUD study in 2000, we wouldn’t

have had this crisis. But I’m just saying, these are --

these issues in the subprime marketplace, in some

regards, the poor -- the poor selling practices were

known.

Down the chain, the underwriting practices

were starting to reveal themselves; but I think by the

mid-decade, you had a lot of changes, and there was a

lot of practices –- really bad practices in the chain.

Starts with the mortgage finance companies,

many of them weren’t federally regulated. I think we

7


have a very patchwork-quilt sort of environment for

regulation.

Most -- not all, but most of the firms that

came into trouble weren’t even federally regulated in

the mortgage -- in the origination chain.

But it goes all the way through the

underwriting practices, all the way out to the main

Wall Street firms, as to how they were…

So that gets to my next areas, the rating

agencies. I think they’re gatekeepers. The gatekeeper

function of underwriting, the gatekeeper function of

rating agencies I think very much broke down. And I’m

not even -- I’m not even suggesting it’s a lack of

regulation. I mean, I just think -- and the rating

agencies had, for decades, rated basically corporate

bonds and state municipal bonds. But by the late

nineties, you started to have these new, structured

deals. There was a whole opportunity for the rating

agencies to grow and to build upon and to compete.

The model was very much underwriter-directed,

picking your rating agency. And you didn’t have to pick

three of them. Like most corporations actually get two

or three ratings. So interestingly, the rating agencies

didn’t necessarily have to compete as much. But I think

in this structured-product area, the rating agencies

8


were very -- they very much were remiss in their gate --

sort of what I call the “gatekeeper function,” the

critical review of these things.

So it was a little bit part -- not “a little

bit.” I think that’s a key factor.

There’s a whole bunch of other things that

I’ll mention before I do derivatives, which I’m doing

shortly.

We didn’t have consolidated supervision of

complex financial institutions. This was something that

was known, even, in the nineteen-nineties. I mean,

Europe -- as Europe went to the concept of consolidated

supervision, they would raise it with U.S. regulators.

All right, you’ve got the -- there’s a Holding Company

Act that came out of the 1950s. So banks, when they

started to have multiple banks -- you know, you might at

first have multiple banks in the same state; and then by

the 1970s and 1980s -- I guess 1980s you start to have

them cross-states. The concept of a holding company, so

the Federal Reserve was that.

But when the investment banks started to do

affiliate structures, you had the SEC regulating the

broker/dealer, but nobody technically had regulation of

their affiliates.

You’ve probably studied the -- what’s that,

9


CSE program over at the SEC?

MR. SEEFER: Yes.

MR. GENSLER: But there was no effective

consolidated supervision of the investment banks. There

was no effective consolidated supervision of anything

that had an OTS label on it.

I mean, I think -- so AIG fell into that

category.

So I think that’s another -- that was a real

gap in the system, consolidated. And that means

consolidated capital, consolidated risk management

across the whole platforms.

I think the capital standards themselves

played a role in this; that partly in Europe, BASEL III,

I think, left a lot of holes, but CSE program –-

BASEL II, I’m sorry -- that the CSE program picked up

the capital standards of BASEL II as well -- you know,

the risk management approach there. And it plays into

derivatives, which I’m going to hold a little bit on,

but I think that’s part, the capital standards.

And then the last thing I’m going to mention

before I talk to derivatives, I think modern finance,

and probably finance of the future, will never repeal

the tendency of a crowd to all want to get to the door

at the same time. Call it the classic “runs on the

10


bank.” And that wonderful 1946 movie, “It’s a Wonderful

Life,” George Bailey has his little savings and loans,

and all the depositors want to get the money out. And

the angel, of course -- you know, we had an angel, you

know. We didn’t quite have an angel in this scenario

but…

The modern run in this crisis you saw in

several scenarios, but -- you saw it in money markets,

when the reserve fund broke the buck that Wednesday of

the fateful week; you saw it in prime brokerage

relationships between hedge funds and investment banks,

when -- after Lehman failed, there was so much intense,

severe pressure on Merrill, Morgan Stanley, and Goldman

that the prime brokerage relationships would pull all of

the securities out. That’s technically pulling out the

stock loan and the tri-party repo.

But what I think -- and I don’t think we’ll

repeal that. I think that the tendency to crowds to all

want to get through a narrow opening in one moment of

crisis, you know, is something that rather than saying

we’re ever going to repeal that, we have to make sure

that we build our financial institutions and regulations

to anticipate some of that. The runs on the bank of the

George Bailey circumstance is very different now.

But I think what we’ve failed is, these

11


institutions, whether it was the largest amongst them --

Citicorp or others -- I think had a fundamental mismatch

and a weak appreciation for what happens to liquidity

and funding in crisis. And I think that these large

financial institutions -- here in the U.S. and in

Europe -- had a tremendous, I would say, overreliance on

short-term funding that could have been in the money

market desk, through tri-party repo, through stock loan,

so forth; which, of course, all of that was then getting

their money from the mutual-fund industry -- the money

market was about $3.6 trillion in money markets.

That -- in a crisis, when that gets pulled,

their assets were always illiquid.

Now, some could say, “Listen, that’s what

financial intermediation is.” Financial intermediation,

at its core, is bringing together people who have money

and people that need money, and you stay out of the

middle of that. It’s bringing to people that have a

risk and want to lay off that risk, and somebody who is

willing to bear the risk. You can think of insurance,

in a way.

But also financial intermediation is about

maturity mismatches. You know, George Bailey has a

maturity mismatch. All those depositors give him money,

and then he puts it out in 30-year mortgages. The

12


maturity mismatch is something at the core of financial

institutions. But I think that the regulators just

haven’t had enough cushions for liquidity runs. And

that many of the assets -- the assets of Lehman Brothers

were probably terribly mismarked. That your study of

Lehman Brothers would be about a lot of issues about how

they did 105 repos and how they put things off balance

sheet, and your study of the big banks will be how they

put stuff off into special-purpose things called SIVs

and so forth. But I also think that on the assets side,

they were fundamentally misjudging how illiquid these

things were just because they put it inside of a loan.

Lehman Brothers had a lot of things they

called commercial loans. Now, if you make a

$100 million loan against a building that’s worth

$105 million, it is a loan, but now the building’s worth

$95 million, you know, a month or two later, it feels

like more like you own the building. So is it real

estate or a loan?

And so I think that’s my last thing before

derivatives.

I could go on. But you guys have a lot of

fun. You’ve got a lot to study.

Derivatives, is this what you guys want me to

cover?

13


MR. SEEFER: Yes, it is.

MR. GENSLER: All right. Over the -- let me

just say a little bit of background about derivatives.

Derivatives in our country started in the

Civil War. In 1865, just before, I guess, Lee and Grant

were meeting in Virginia, some other people were meeting

off in -- it’s true, that’s when it was, it was just a

few weeks before they were meeting -- off in Chicago,

some grain merchants and millers and everything figured

out that to hedge a risk in corn and wheat, they would

no longer just enter into what was called a “forward

contract.”

A “forward contract” would be that sometime, a

few months from now, I’ll deliver the corn and you’ll

give me money. Somebody invented what was called

a “futures contract.” It was that a few months from

now, at harvest time, I might deliver the corn and you

might give me the money, but I also have a right to

financially settle that contract. I don’t have to

physically deliver. That was the great innovation in

1865 that started the derivatives market.

A futures contract was just that simple

somebody planting and growing and milling corn or wheat

could protect themselves against the future price of

corn or wheat, and would not have to actually,

14


physically deliver the corn or wheat, or not physically

take it into their stocks.

It was also a way to discover prices on a more

national or regional basis than just what the local, you

know, fellow would buy it for.

It took nearly 60 years to first regulate

that. In the early 1920s, the Grain Act was passed.

Right, Dan? Do I have that right? It went

all the way to the Supreme --

DAN: ’22, ’22.

MR. GENSLER: ’22. It went all the way to

the Supreme Court, and then it was declared

unconstitutional, actually, because they said it might

not have to do with interstate commerce.

Well, they fixed it. They put a couple of

different clauses in and they did it again.

The core thing -- and then by 1936, just the

same way that Roosevelt went to Congress and said that

we had to protect the securities markets against

manipulation, Roosevelt went Congress and said, “We have

to protect these commodities markets.” But it was

fundamentally derivatives markets from manipulation.

They were all agricultural commodity derivatives at that

time. There was no interest-rate swaps. There was no

oil swaps.

15


But the fundamental things that were done

then, was they had to be on transparent exchanges, and

it was a mandate. All of them had to be on exchanges.

And they give some authority -- our predecessor -- some

anti-fraud and anti-manipulation authorities, of course.

And then there was an innovation from the

1890s called, “Clearinghouses.” Clearinghouses are

just middle men that stand between a purchaser of a

derivative and a seller of a derivative; and on a daily

basis, ask for performance money to be posted because

they’re valuing that derivative on a daily basis.

This history will be relevant.

So that’s about where it stood. But then you

get to the early seventies, and people start to do

derivatives on equities. They were called “stock

options,” but they were a form of derivative. An option

is a form of derivative. And they started to do it on a

centralized exchange out in Chicago. And there was this

debate how to -- what do we do about that, how do we

regulate it and so forth.

And so what came out of that period of time is

that our predecessor got pushed out of the agriculture

department, got broad, new authorities over all of what

was called “futures.”

“Futures” are basically on-exchange

16


derivatives. So we picked up authority for oil futures

and financial futures and so forth.

And by 1980, probably, all derivatives

contracts were on exchanges, and the majority were

financial by 1980, they were mostly on the equity

markets, or they might have just started on the Euro

dollar contract in the late seventies, I think.

Well, in 1981, over at Solomon Brothers,

somebody brokered a trade between World Bank and IBM on

a currency derivative. Or at least the story goes.

MR. SEEFER: Uh-huh.

MR. GENSLER: And the start of what was

off-exchange derivatives or unregulated derivatives

occurred. They initially were bilateral.

They were initially, actually, brokered. They

weren’t taken onto the bank’s books. But within several

years, all the banks said, “We’re going to -- this is a

line of business. We’ll actually take the thing right

onto our books.” They sort of operated as the central

clearer, in a way, without asking for performance money.

They were customized. And, of course, we

didn’t live in a world where people could walk in with a

computer. You know, there were no computers. I’m old

enough to remember.

MR. SEEFER: So were we.

17


MR. GENSLER: Yes. I don’t think your

colleague is.

There were debates. There were debates as

early as probably ‘87, ‘88. Our agencies got

reauthorized every, about five years. There was a big

debate in ’92: What do we do about these things now

that are called “swaps”? So derivatives are futures and

swaps. The on-exchange derivatives fully regulated, and

they were called “futures.” These off-exchange

derivatives, which were mostly bilateral, customized,

not done in any central place, no central clearing, what

do we do?

And late in the eighties and by ‘92, there was

a growing, sort of pressure from Congress, probably from

industry, maybe even from the regulators, that this

needed to be addressed.

So in 1992, I guess, in our reauthorization,

there was a provision that we’d have an exemption

authority. And we were specifically sort of suggested

in the committee report, not in the statute, that we use

the exemptive authority to exempt this whole class.

And Wendy Gramm was chairman then. And before

she left in January of ‘93, she put out the swaps

exemption.

There was a swaps policy statement for three

18


or four or five years earlier. We can summarize all

this history, but I’m just trying to -- but, I mean, the

swaps policy statement, either in the late eighties or

early nineties -- do you remember when it was?

MALE VOICE: Late eighties.

MALE VOICE: Late eighties.

MR. GENSLER: Yes, the swaps policy statement

in the late eighties, and then the exemption that

Congress -- I mean, Congress granted the exemptive

authority. So in a sense, Chairman Gramm used the

exemptive authority. There was this --

The thinking at the time -- we can look back

now and say, “Things should have been done differently,”

and all that. But the thinking at the time, I think,

was -- I captured this in a speech I gave up at Columbia

University -- Joe Stiglitz asked me to go up there, and

I did this a month or two ago, we could send you that

one. But I think -- and even through the late nineties,

because I could go through the Brooksley situation,

too -- well, let me just go through the history and then

I’ll give you the thing at the time.

So there’s also a really critical moment

there, that Brent Crude Oil’s thing was about then, too.

There was this -- whether a contract was traded on Brent

Crude was a future and should be on an exchange. It

19


went into a court situation. The Court said it could be

a future, it was a future.

And so one of the other things that happened

in ‘93 was, there was also that was exempted here. So

there was two things: One under Gramm, but the Brent

thing, I think, happened a few months after she left. I

can’t remember.

MALE VOICE: The energy exemption was a few

months after.

MR. GENSLER: Yes, so the energy exemption was

a few months later.

The thing got tested a little bit when Mary

was in my job -- Mary Schapiro was in this job in the

Metallgesellschaft case, she tried to sort of test the

outer boundaries, the question -- the legal question

was: Were swaps futures? Because our statutory

language at the time said futures had to be on

exchanges.

It didn’t say “derivatives,” it said

“futures.” And so there was a legal question: Are

swaps futures?

Everybody knew that swaps and futures were

pretty similar, but were they technically futures? That

was this legal question.

Throughout the eighties, people said really

20


not. But, you know, as you got into the nineties, they

started to have some characteristics.

Wendy Gramm’s swap exemption was, they had to

be bilateral; they had to be individually negotiated;

they, thirdly, couldn’t be on central clearing.

Let’s see, individually negotiated, bilateral,

not cleared.

She had a fourth characteristic.

I don’t know, it’s still in our Part 35. You

could find it in Part 35.

So that was the sort of conceptual framework.

Mary sort of tested a little this futures swap

things in the Metallgesellschaft case. There was a lot

of back pressure. The case got settled. Mary went over

to NASDAQ, and then Brooksley came.

A critical thing in the history is also the

SEC. There was a little bit of turf thing going on

with the SEC, too. The SEC did something called “broker

lite” in late ‘97, where the investment banks wanted to

set up affiliates to do derivatives business. The

question is, how do they get regulated? The

broker/dealers didn’t want to keep their swaps business

in the broker/dealers. They wanted to do, if I can use

the term, be capitally efficient, or use capital --

arbitrage, if you wish -- and put it in an affiliate,

21


not in a broker/dealer. And somewhere late in ‘97,

there was something called “broker lite.” I can’t

remember its details. Might be Cyrus remembers the

details.

MR. SANATI: Especially, BASEL II, you used

internal risk-rating methods --

MR. GENSLER: For that --

MR. SANATI: -- to calculate the requirement

for broker/dealer lite. And that enabled them to get a

higher credit rating, so that all their counterparties

could be -- could treat them as though they were -- if

not AA, even higher.

MR. GENSLER: Right, right.

MR. SANATI: So it was capitally efficient,

not just for, if you will, Goldman and Morgan and

Merrill --

MR. GENSLER: Right, right, right.

MR. SANATI: -- but for the counterparties as

well. And I understand part of that motivation.

MR. GENSLER: Right.

MR. SANATI: It was also to get away from

BASEL I and get into that internal risk rating of

BASEL II where banks --

MR. GENSLER: I think, though, as sometimes

happens with regulators, it also then became a little

22


bit of a -- you know, that was an SEC thing, it wasn’t a

bank thing, it wasn’t a CFTC thing. I mean, there’s

probably a little of that, too.

The banks -– the investment banks and that

did -- and this is part of the rating-agency story,

too -- started to have swaps affiliates that they would

then go out and work with the rating agencies to get

credit ratings on, to try to do triple -- they were

single-A -- they were single-A -- Goldman, Morgan

Stanley and so forth were single-A, but they tried to

get their affiliate to be triple A or double A, at

least, where they would do credit enhancements and

they’d work with the rating agencies, highly negotiated

to get those swaps affiliates.

I think the missed opportunity -- and we

raised it in 1980, after long-term capital management

fell in ‘98, I guess it was in the spring of ‘99, the

Treasury and the President’s working group did a report

on long-term capital management. And it was basically

a report on excess leverage and how to deal with -- I

guess the report’s name was, “How to deal with highly

leveraged institutions.” It had a series of

recommendations, some of which related to markets and

bank regulation but some related to Congress. One of

them was that we needed enhanced regulation of these

23


swaps affiliates.

There was a footnote in the report, because

Greenspan and Rubin didn’t agree on this. I remember

because I had to personally negotiate between the two of

them as a staffer -- I mean, I was an assistant

secretary, but I was like taking each of their language

and trying to get the footnote at the time.

So the issue of regulating the swaps

affiliates was known in that report. In the spring of

’99, it was recommended with basically a -- whatever you

want to call it, a lack of concurrence from Greenspan.

But it was sort of -- it’s buried in a footnote, the

lack of concurrence.

And then this agency, under Brooksley’s

leadership, put out the concept release in the spring of

‘98. You all know that history well.

It kicked up the same legal question: Are

swaps futures? Are futures derivatives? You know, that

whole -- it was in the context that Europe didn’t

regulate derivatives and Asia didn’t regulate

derivatives. But it was in that context.

And then the Commodities Futures Modernization

Act, which I’m not -- you know, I mean, I could go

through, but you kind of have --

MR. SEEFER: Uh-huh.

24


MR. GENSLER: But I think the five things --

and Scott could send you the thing because Scott helps

me in all my speeches and he’s our -- he runs the press

area -- the five things as to why, I think –- and these

are just my views, these aren’t the CFTC views – but

I think the five areas that I think of that why, over

these decades, why Europe, Asia, and the U.S. didn’t

bring this under regulation, because it’s not just here.

MR. SEEFER: Uh-huh.

MR. GENSLER: I think that, first, there are

three somewhat intertwined assumptions, but let me see

if I can remember them without the speech in front of

me.

One assumption was that the parties to these

contracts were all sort of sophisticated parties. Big

girls, big boys -- you know, large enough to fend for

themselves.

Two, was that the institutions that were

operating as dealers, what we are now calling “swap

dealers,” were basically regulated, anyway.

And, three, that somehow that market

discipline amongst these sophisticated parties with the

institutions generally regulated, anyway, would kind of

work.

That third one is sometimes associated with

25


Chairman Greenspan; but, I mean…

The first assumption, that they’re all sort of

large, sophisticated actors, and so do they need

protections, I think sort of, in a sense, has proven out

to ignore that there’s larger, broader, more, you know,

systemic implications, even if you’re saying -- even if

you believed -- and I’m not saying I do -- but even if

you believed there wasn’t a need to, you know, protect

individual actors.

We’re -- actually, this gets into our

recommendations. We’re proposing -- and it looks like

we may be able to be successful in this -- that the SEC

and CFTC have explicit role-writing authority to protect

business conduct, protect business conduct from fraud,

manipulation, and other abuses in this marketplace. But

that would have been unheard of through this debate,

that this sophisticated marketplace should have such

protections of fraud, manipulation, and other abuses.

This second assumption, that kind of these

actors were well, kind of regulated, anyway, and I would

say even looking back, because I was part of the Clinton

Administration, though I was recused during the year

with Brooksley and my boss, the Secretary was having

that sort of thing -- because I was just in my first

year from Goldman Sachs -- I would say that I was

26


probably prone to this false assumption, too -- the

second assumption, is that the large dealers were

regulated.

Where that breaks down is, it wasn’t really

true for a lot of them. The affiliates of the

investment banks, the AIG affiliate, they weren’t really

effectively regulated.

And even if you were in the middle of a bank,

even if you were in the middle of a large bank and you

were regulated by the bank regulators, you weren’t

explicitly regulated for capital.

To this day, there is no -- you cannot go to

the OCC or the Federal Reserve or BALS [phonetic] Web

site and say, “Where is the capital rules just for your

swap business?” It’s sort of like -- it’s embedded in

everything else. It’s not explicit.

There’s not explicit rules about how to do

netting and back-office documentation, and so forth.

But certainly, as the case of AIG proves in

spades, there was no effective consolidated holding

company regulation and, thus, there was no effective

regulation of its derivative affiliate. There was

no -- I would contend, no effective consolidated

holding-company regulation of the investment banks.

The CSE program didn’t really -- I mean, it

27


was better than what was before, maybe; that there was

somebody looking into the affiliates, but very light,

apparently.

The third assumption -- I never really

believed much in but, you know, there’s too many

externalities, there’s just too many externalities to

leave it to chance.

The fourth and fifth thing that I think of is,

there was always this sort of thing that these are –-

[Cell phone buzzing]

MR. GENSLER: -- these are -- these markets

are highly -- these -- I’m sorry, these hedging

transactions are highly customized and bilateral. That

was absolutely the case in 1981.

That may have still been the case in 1993 --

in January of ‘93, when Chairman Gramm put out this

swaps exemption.

[Cell phone buzzing]

MR. GENSLER: My problem is, it’s my daughter.

So let me just do this for a second, I think.

[Off-the-record conversation on cell phone in

background and simultaneous off-the-record

discussion between FCIC staff]

MR. GENSLER: I’m sorry.

MR. SEEFER: That’s okay.

28


MR. GENSLER: I’m a single dad, so like every

time they call, I pick up.

The other assumption was that they’re

bilateral, they’re basically highly tailored, they’re

not susceptible to centralized market structures. I

think that’s something that was probably way true in the

eighties, it became less true in the nineties, it became

a lot less true once computerization took off.

You know, in 1993, when Chairman Gramm put out

the thing, there was really no Internet. I mean, you

could sort of go do the statistics.

And even in the late nineties, there was no

electronic trading. I mean, the New York Stock Exchange

was still very much a specialist system, the derivatives

markets in Chicago and New York, what we call the

Chicago Mercantile Exchange and the New York -- and

NYMEX were in the pits, were on the floor.

And in the late nineties, you just started in

‘98 and ‘99 to have a little bit of this starting. The

Commodities Futures Modernization Act provided some

provisions. It was meant to sort of capture some of

those emerging issues. Some of them didn’t take off.

There was something called DTEFs put into

that. But Jeff Sprecher started ICE as an exempt

commercial market. But it was just beginning that

29


electric platform.

So I think the last ten years there’s been a

lot of evolution towards centralization. In front of

your commission, Jamie Dimon was asked by Brooksley

Borne what percentage of the market could be brought to

central clearing, and he said, in January, 75 to

80 percent.

I want to thank you all for having that

question, because I quote that often now in speeches.

He’s -- I’ve seen him since then at one

meeting; and he said, “Well, maybe 70 to 80 percent.

But he still -- the point being that that would not have

been the answer ten years ago, and certainly 20 years

ago. That the standardization in this market has -- and

whatever the standardization, whatever the number is,

it’s far greater today than it was before.

And the last thing that I think was of debate

about why these should be regulated and not regulated

and so forth is, “Well, we can’t do it here. Well, I’ll

go overseas.” You know, sort of that whole thing, which

is -- listen, that’s a real, live issue at all times.

It’s even in what we’re doing right now.

We have a remarkable confluence of views

between Europe and the U.S. I think we have very good

views between the U.S. and Mexico and Canada and Tokyo.

30


We’ve been sort of walking this derivatives legislation

through internationally. But we still will end up with

different cultures and different political systems, with

a little variation in this. And there will be some

gaps.

But if -- I think that you cannot diminish the

influence of this, that these contracts were not

regulated in Europe and Asia and anywhere else has even

on the mindset here in this country.

So they tell me I have to leave. But you want

to know what role derivatives played in the crisis? I

think it was a very real role. I think it was a role --

and I’m going to summarize -- but I think -- I think

over-the-counter derivatives are important hedging tools

for corporate and municipal governments. But they do

allow for risks to be concentrated. They’re meant to be

risk-management tools, and to lower risk for the users,

and they generally do that. They don’t always do that,

but they generally do that. But at the same time that

they do -- generally do that for the end users, they

have tended to concentrate and heighten risk within this

financial institutions.

Financial institutions, when they started this

in the eighties, started brokering these transactions

but quickly decided to keep them on their books.

31


MR. SEEFER: Uh-huh.

MR. GENSLER: And as the business grew, they

found that very profitable. They charged for the credit

extension, because you’re extending credit when you’re

doing these transactions; but they’d also charge for the

market-making. They were not moved to central clearing,

so the risk stayed within these books.

And in the United States today, there’s really

five large financial institutions that have the bulk of

this business, 95-plus. And you might say there’s five

to eight overseas.

Now, we could give you a list of 25 swap

dealers; but, you know, when you really say where it’s a

highly concentrated and dealer-dominated business. It’s

not unusual. The airline industry got concentrated, the

auto industry, the drug industry. But this has enormous

externalities to it, you know, I think.

And I think it does heighten it and

concentrate risk. That’s why I’m such an advocate that

we mandate central clearing, that we move as much as we

can off of the books of these.

AIG, I think, highlighted those risks because

when the money went into AIG, the first $90 billion,

$60 billion of it went straight through AIG to other

counterparties. I mean, it was fulfilling counterparty

32


claims, both on their swaps books and I think on their

stock loan. So it’s not the first sixty wasn’t all

because of derivatives.

I think a second thing to consider about how

they can heighten it -- so I’m still on my first point

of heightening and concentrating risk, but if you want

to make it a separate point all together,

over-the-counter derivatives can add to the leverage

in the system.

“Leverage” is usually thought of as how

many dollars of borrowings do you have for every dollar

of capital. And that’s the classic, you know,

first-semester finance answer what “leverage” is. But

in the modern world, you can put a lot of that same

borrowing, if you wish, in the form of an

over-the-counter derivative. And so it can add a great

deal of risk.

Long-term capital management, I had the phone

call on a Saturday in 1998 to go up to Long-Term Capital

Management, the Secretary, then Rubin, asked me to go

up. And Peter Fisher from the New York Fed and I went

over there. Well, they had a $1.3 trillion derivatives

book and they had $100 billion balance sheet. And, of

course, not $100 billion of capital. They had about

$4 billion of capital.

33


So the $4 billion of capital in this hedge

fund was leveraged 25-to-1. The derivatives book of

$1.3 trillion notional amount -- that doesn’t

necessarily mean that’s a leverage ratio. I don’t want

to misstate people and say, “Oh, my God, that’s 200,

300, and 25-to-1.” No, it’s not that. But you can put

so much risk in an off-balance-sheet derivatives book

that then is also riding on top of that small. And I

think that we saw that, in large measure, of course, at

AIG. Less so elsewhere. But I wouldn’t diminish that

it was elsewhere.

The second big thing about how derivatives

played a role in this is in the home-mortgage

securitization chain. That whole chain we were talking

about earlier. Derivatives and credit default swaps,

more specifically, were used in that chain.

Credit default swaps didn’t really exist.

They were a blip on the screen.

I will tell you, in 2000 -- and I didn’t

participate in every meeting on this Commodity Futures

Modernization Act; it wasn’t -- I mean, there was a team

of people at the Federal Reserve and the Treasury and

the CFTC and the SEC. But the meetings that I was in,

I never remember the word “credit default swap” coming

up. And what I’m sure of is, nobody ever, like, said,

34


“Let’s have a whole meeting on it.”

But what I’m saying is, I don’t even remember

it coming up. It’s possible. It’s possible somebody

would put in front of me a piece of paper that has the

words on it, and will my name on it. But it’s -- it was

such a small part of the market, and it was just

starting to happen over at JPMorgan and so forth.

But that product by 2004 and 2005 was being

used in a way in this securitization chain that I think

had some very adverse effects.

People were effectively trying -- selling

their credit rating. AIG was renting for what, in

hindsight, was too cheap a premium; but they were

renting their AAA rating that they used to have through

credit default swaps foremost into these collateralized

debt pools, but also to European banks.

European banks -- I don’t want to diminish --

European banks had, I think, $300 billion of credit

default swaps with AIG. I can’t remember. AIG had

$450 billion of credit default swaps, and either

one-third was to Europe or two-thirds. I just

apologize, I can’t remember.

MALE VOICE: It was mostly Europe.

MR. GENSLER: So two-thirds. So about

$300 billion was to Europe. And the European bank

35


regulators were taking the AIG credit and lowering the

capital charges to the European banks.

MR. SEEFER: Uh-huh.

MR. GENSLER: And the effect of it, was that

AIG was a house of cards that came down, and you -- and

this is part of how it concentrated and heightened risk,

is because it’s so interconnected, that the financial

system at large was so interconnected by all the

derivative trades between them.

Clearinghouses can compress all that, can take

a lot.

And the first $7 billion of credit default

swaps that are now in ICE -- you should interview Jeff

Sprecher about this -- but ICE Trust has about seven.

You would think that 7 -- $7 trillion -- I’m

sorry, $7 trillion out of the $28 trillion notional is

now in ICE Trust. I think they have found, on average,

I think he said to me recently, 15 parties when you do

the chain. Somebody buys it, somebody sells it,

somebody buys it, somebody sells it, somebody buys it.

So when all of this book of business is coming

in, they’re finding out that the daisy-chain is

compressing. And instead of $7 trillion, it’s like

1/15th or 1/20th or something -- no, it’s well less than

a trillion. But it compresses down, I think to like

36


$500 billion or $600 billion.

You could ask Jeff. He could…

But back to the story. So it heightened and

concentrated risk. I think secondly, it was very much a

part of this mortgage underwriting chain. Now, you

know, it’s very topical. I’m sure part of your report

will look at synthetic CDOs and so forth. But even if

they weren’t synthetic CDOs, what was happening is it’s

like the old bond underwriting thing. I mean, we should

know, one of the early signs of this crisis was

Bear Stearns’ problems, but it was also that MBIA and

AMBAC, bond underwriters, they were selling as insurance

companies what used to be called in the trade “bond

wraps,” where they were wrapping their credit rating;

they were selling cheap insurance so somebody could get

their credit rating.

I can’t remember which month in ‘08, but they

went down well before September, right. And that was

like -- what’s that?

MALE VOICE: January, the New York State

Insurance Department had big concerns to everybody

together.

MR. GENSLER: Right, right. So there was

eight to ten -- MBIA, AMBAC and, obviously, AIG -- but

there was like seven to ten others that were basically

37


selling credit default swaps heavily -- they’re probably

all under now, I don’t even know the list. But mostly

to this mortgage chain.

But, of course, it’s in the context of, you

know, an asset bubble. Like if -- but which came first?

What created the asset bubble?

You know, and everybody do some of this. But,

you know, is it our global imbalances, is it poor

underwriting practices, is it credit default swaps, is

it poor underwriting standards, where the investment

banks were sort of shoveling in and shoveling out? But

I think the derivatives paid a very central role to this

mortgage underwriting chain through credit derivatives.

I think I’m probably out of time.

What else are we going to say? If they ever

ask us to testify, what else am I going to say,

Cyrus? Because you’re thinking about this, how do

derivatives --

MR. SANATI: I think as part of the

interconnect of the story is the -- and the opacity of

the market contributed to some of the runs that you were

talking about. So when a counterparty doesn’t know what

kind of a derivatives counterparty, their counterparty

is involved with, it increases the uncertainty.

MR. GENSLER: The on-exchange derivatives

38


markets futures have had a discipline, really, since the

1890s, but by mandate by law since the 1930s to use

central clearing. But clearing has a mandate within

itself that every day, the value of the transaction, and

the obligation of each of the parties is to send some

money. Somebody will send some money, one way or the

other.

This marketplace, when it grew up, first in

the eighties and nineties, there was no central

clearing. There’s a little bit of central clearing,

voluntary clearing now, but only in the last ten years.

But Cyrus is absolutely right, the

interconnectedness is there -- I have to go? -- the

interconnectedness is there, but it then has to be

coupled with this Cyrus use of fancy lawyer

word, “opacity.” I would say darkness, but I’m a

finance guy, and he got his Ph.D. in history.

It’s true; isn’t it?

MR. SANATI: Yes.

MR. GENSLER: But what happens in a run -- go

back to George Bailey’s situation -- but what happens in

Iran is everybody’s running for safety. Everybody’s --

when I said it’s everybody trying to get out the door,

think of a theater and somebody screams, “Fire.” I

mean, just think of the visual. That’s how financial

39


markets work in a crisis or a panic.

We had a little of that on May 6th, they were

studying now, the SEC and we are studying.

So everybody is trying to run to safety. And

derivatives in that moment, that are not centrally

cleared, create more uncertainty.

Will my counterparty be able to perform, and I

have a 30-year open contract, and a 30- or 20-year open

contract on oil or interest rates or whatever, but will

they be able to perform. And if am worried that they

won’t be able to perform, I’m not going to enter into

any more trades with them, but I’m also going to try to

find any way that my lawyers can trigger the current

trades. I think that’s what you’re referring to.

Whereas the central clearinghouse model, it

can’t do it for 100 percent of the market; but if

Jamie Dimon’s right and says it’s 75 to 80 percent of

the market, that’s a heck of a step forward to put

three-quarters of the market into the central

clearinghouse functions.

I think, in September of 2008, the biggest

story on derivatives was clearly AIG. I’ve been accused

by some opponents to reform, that we’re using AIG to try

to ride to get all of this stuff.

Those people would say it’s all about a couple

40


of things. They would say it’s only about consolidated

supervision. If we only had reform to bring

consolidated supervision, AIG should have had somebody

looking over the whole thing. And secondly, it’s about

credit default swaps. Credit default swaps mean lots of

regulation.

I would say that would be the core the

opponents would say.

When President Obama’s transition was meeting

and it was then just Tim Geithner, Mary Schapiro and

myself, not like big buildings with lots of staff, none

of the three of us thought it was just that. I mean, it

was all -- we have to cover the whole product suite,

interest-rate derivatives, currency derivatives, oil and

commodity derivatives, equity, credit default swaps. So

the only suite of products.

And then it wasn’t just about regulating the

dealers, the swap dealers being the consolidated

supervision; but we had to have a mandate for clearing.

And then the toughest political question was whether we

had a mandate for trading.

But we basically, by January of ‘09, sitting

in that -- I remember that office, that transition

office -- said, “Let’s” -- I mean, it took a lot more

months to get this all written up -- but, “Let’s do the

41


whole product suite,” you know, and, let’s not just

focus on the dealers, but the three key components of

reform or comprehensive dealer regime, mandatory

clearing for that 75 or 80 percent that conclude

cleared; and then what was most politically charged was

a mandate to bring as much of that 75 percent -- maybe

not all of the 75 percent, but as much of it to some

central trading.

And if there’s not enough liquidity for the

trading, at least have real-time post-transition

reporting.

So that’s the story. Next time you interview,

I might have a different story.

MR. SEEFER: That would be very interesting.

Again, I know your time is short and I

appreciate the time. We’ll talk to Tim about --

MR. GENSLER: And I apologize because I just

did a monologue. That wasn’t much of an interview.

MR. SEEFER: No, but you know what? Now, we

can digest this and come back and pepper you with some

questions.

MR. GENSLER: Are you the derivatives team, or

are you doing everything? I mean, what are --

MR. SEEFER: Both. Yes.

The way we are doing things is looking at

42


everything the entire year but focusing on certain areas

within that as we gear up for hearings on a subject.

And the next hearing, among other things, is going to be

on the role of derivatives.

MR. GENSLER: Can you –- let me know, because

it’s quite possible you’re going to give me a formal

invitation -- what’s the date?

MR. SEEFER: The date, as of now -- and it has

changed once already -- would be either June 30th or

July 1st.

MR. GENSLER: Okay.

MR. SEEFER: No decisions have been made.

Or else we would have brought a formal

invitation.

MR. GENSLER: Right. Yes, yes, yes.

MR. SEEFER: As if you are right, that we are

certainly considering you.

The folks are up in the air on what exactly do

we want to do at the hearing. And now that it got

pushed to the end of the month, people will figure they

have more time to think about it, I suspect.

But Chairman Gensler has always been on a list

of potential witnesses for a hearing.

MR. GENSLER: I’d be honored to do it. If you

don’t invite me to, I’m honored to.

43


I think -- I hope by then the President will

have signed a financial reform bill that we’ve got

through House and Senate conference. But nothing’s ever

certain in Washington. But I think it’s still very

relevant. What’s the history of -- how did derivatives

play a role in this particular crisis? I think they

magnified and concentrated risk and leveraged; and I,

secondly, think that they had a very, I would say,

corrosive role in the mortgage underwriting process.

The whole -- the whole mortgage underwriting and

securitization chain, those would be the two things that

I would have to prove out -- I mean, Cyrus would have to

prove out in my written testimony.

And then, you know, if you wanted me to talk

anything about the history -- I mean, I think the

history, which I captured in that Columbia speech is

just -- I mean, certainly I think about it. Knowing

what we know now, should those of us that were in those

roles back then done more? Yes, yes.

But we didn’t know then what we know now.

And these assumptions, these five

assumptions -- you know, you have this sort of broad,

international debate that would peak up in ‘87 or ‘88,

‘92, ‘98, you know. And each time that the debates --

and they probably had their other debates in Europe,

44


too -- I think those were some of the factors why people

said, “No, maybe not. It’s really an institutional

market. We’re kind of regulating these folks, anyway,”

and other kind of unique and bilateral. You know, those

points.

MR. NORMAN: If I can digest quickly what you

just said, it had a corrosive role in the mortgage

origination process?

MR. GENSLER: Mortgage underwriting and

syndication.

MS. NORMAN: By making it seem safer by

taking -- or wrapping them?

MR. GENSLER: I think -- not on the streets

of, you know, Seattle or Baltimore or anywhere, where

somebody was getting -- I mean, I think that there were

bad practices by subprime brokers. I don’t think it had

a direct role there. I think further down the chain, I

should have said, if I did, mortgage underwriting and

mortgage securitization.

But you have to take -- I mean, I don’t know

if you’ll do it this way, but a mortgage all the way

from, you know, the homeowner, all the way to the other

end, that’s packaged in a sliced-up synthetic CDO. I

think they did have a corrosive effect further down the

chain in terms of the underwriting practices and the

45


syndications. Because in the syndications and

underwriting practices, they basically, when you leave

parties, investors with a sense that they have less

risk, they’ll pay more for something. It’s part of what

leads to a bubble when risk is mispriced.

I mean, fundamentally, though there were many

causes of the crisis, one of the big central themes of

the crisis is risk, is always in society, but it

sometimes gets mispriced. And I think -- I think risk

got seriously mispriced in this, the risk of individual

homeowners defaulting; the risk overall of an asset

bubble declining. People didn’t call it a bubble, just

the risk that housing prices would decline was

underpriced.

And the other risk that I think was

significantly underpriced was the earlier risk I had

talked about, liquidity risk, which doesn’t directly

relate to derivatives.

But I think that -- I think liquidity risk was

fundamentally underpriced. I think the risk that

overall asset values would decline was underpriced and

under-appreciated.

I think the risk of homeowner default was

ultimately -- and the rating agencies played a role, bad

underwriting practices played a role; but credit default

46


swaps played a role in that.

Does that help?

MS. NORMAN: Yes, I was just trying to figure

out the --

MR. KARPOFF: We really have to stop.

MS. NORMAN: Sure.

MR. GENSLER: Tim. Iron-fisted Mr. Karpoff.

Come on, everybody’s got to have a

Mr. Karpoff.

MR. SEEFER: You’re right.

(End of interview with Gary Gensler)

--o0o--

4813-3605-2230, v. 1

47

Financial Crisis Inquiry Commission · Web view2016/03/11 · And that is, to get your opinions on...

Documents

Transcript of Financial Crisis Inquiry Commission · Web view2016/03/11 · And that is, to get your opinions on...